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CASE16 CASE 18 6/25/2016 Student Version Copyright 2014 Health Administration Press SOUTHEASTERN HOMECARE Cost of Capital This case illustrates the cost of capital estimation for a business with two divisions that operate in diverse business lines. The spreadsheet calculates the cost of debt based on the yield to maturity and the yield to call of debt issues that are currently outstanding. It also calculates the cost of equity on the basis of three models: CAPM, DCF, and Debt Cost + Risk Premium. Students must use judgment when making the final estimates for the costs of debt and equity. These estimates must be entered into the lower part of the INPUT DATA section to calculate the corporate cost of capital. Divisional costs of capital can be estimated using the same part of this spreadsheet, but with the appropriate divisional input data. The model consists of a complete base case analysishowever, all values in the INPUT DATA section of the student version have been replaced with zeros. Thus, students must determine the appropriate input values and enter them into the model. These cells are colored red. When this is done, any error cells will be corrected and the base case solution will appear. Note that the model does not contain any risk analyses, so students will have to create their own if required by the case. Furthermore, students must create their own graphics (charts) as needed to present their results. INPUT DATA: KEY OUTPUT: Cost of Debt Input: Years to maturity Annual coupon payment Current price Par value Years to call Call price Cost of Equity Input: CAPM Approach: Beta coefficient Risk-free rate Required market return DCF Approach: Stock price Last dividend paid Cost of Debt: 0 $0.00 $0.00 $0.00 0 $0.00 YTM YTC Err:502 Err:502 Cost of Equity: 0 0.0% 0.0% CAPM $0.00 $0.00 DCF Page 1 0.0% #DIV/0! CASE16 Constant growth rate Debt Cost Plus RP Approach: Risk premium 0.0% 0.0% DC+RP Corporate Cost of Capital Input: The component cost inputs below (not the output above) are used to estimate the CCC. Tax rate Weight of debt Weight of equity Final cost of debt estimate Final cost of equity estimate 0.0% 0.0% 0.0% 0.0% 0.0% Corporate Cost of Capital: CCC Page 2 Err:502 0.0% CASE16 yright 2014 Health ministration Press Page 3 CASE16 Page 4 Cases in Healthcare Finance, 5th Edition Copyright 2014 Health Administration Press CASE 18 QUESTIONS SOUTHEASTERN HOMECARE Cost of Capital 1. What corporate cost of capital (CCC) do you estimate for Southeastern Homecare? 2. The company's financial plan calls for the issue of 30-year bonds to meet long-term debt needs. How valid is an estimate of the cost of debt based on 15-year bonds? If the estimate is not valid, how might it be adjusted to remove any bias? 3. The Board Chair is concerned about factors that affect the corporate cost of capital for any business: the level of interest rates, tax rates, capital structure policy, and capital investment policy. Does the tax rate, cost of debt, or cost of equity have the most influence on the CCC of Southeastern Homecare? Why? (Hint: In one graph, show the CCC at +/- 25% and 50% values of the tax rate, cost of debt, and cost of equity.) 4. Southeastern Homecare has two operating divisions: the Healthcare Services Division and the Information Systems Division. a. Estimate the divisional cost of capital for each of Southeastern's divisions assuming that both divisions have the same optimal (target) capital structure. (Hint: Use the CAPM to produce a cost of equity for each division and assume the same corporate tax rate and debt cost for each division.) b. Southeastern's divisions are each considering two investment opportunities for next year. In which of the projects should Southeastern invest? c. The divisional presidents have expressed concern that a single cost of capital will be applied across the company, regardless of any divisional risk differences. What would be the short-term and longterm consequences of Southeastern using a single cost of capital for both divisions? d. Is the divisional cost of capital applicable for all projects within that division? Explain. e. Suppose that one division has a greater capacity for debt financing than the other (perhaps due to higher asset value and profitability.) How could different target capital structures be incorporated into the divisional costs of capital? 5. The founders of Southeastern are concerned about the threat posed by home health care businesses started by not-for-profit hospitals. Using your answer to Question 4a and the data in Table 18.3, estimate the cost of capital for the homecare division of an average not-for-profit hospital. How much confidence do you have in the cost of capital estimate? Why? 6. One of Southeastern's directors has expressed concern over the difference between the company's target capital structure and the current structure as reported on the balance sheet. a. What are the book values of Southeastern's long-term debt and equity? What are the current market values of Southeastern's long-term debt and equity? b. What are Southeastern's target weights, book value weights, and current market value weights of long-term debt and equity (that is, long-term debt / total capital and common stock / total capital)? c. Which set of weights should be used in the corporate cost of capital estimate? Why? 7. In your opinion, what are three key learning points from this case? 12/6/2013